Lecture 1 & 2

Slide Contents
• Learning Objectives
• Introduction
1.Finance: An Overview
2.Three Types of Business Organizations
3.The Goal of the Financial Manager
4.The Four Basic Principles of Finance
• Key Terms
Copyright © 2011 Pearson Prentice Hall. All rights reserved.

1-1
1.1 FINANCE: AN OVERVIEW

1-2
What is Finance?
• Narrowly speaking, Finance refers only to gather fund.
• But from the broader point of view, it includes all actions
concerning financing plan, funds collection, proper
utilization of funds etc.,
• In short; finance can be defined as the art and science of
managing money.
• In fact, Finance is an art of playing with fund to achieve the
goal. Virtually all individuals and organizations earn or
raise money and spend or invest money. Finance is
concerned with the process, institutions, markets and
instruments involved in the transfer of money among and
between individuals, businesses, and governments.
1-3
Sequence of Finance:
1. Financial Planning: Financial planning means--
– To determine how much money is required
– For what duration
– In which sectors the funds need to be allocated to attain
the overall goal of the firm. etc
• Which is a very important function of a finance manager.
He has to decide what are the profitable projects and in
which projects the firm should invest.
2. Identification of Sources: Secondly the finance manager
has to identify the potential sources of fund. Sources may be
internal or external to the firm.

1-4
Sequence of Finance (Cont.):
3. Raising of Funds: After identifying the different sources, a
finance manager’s next function is to raise the fund from one or
different sources.
4. Investment of Funds: A finance manager’s most important
function is probably to invest in profitable projects. In this case,
the manager has to analyze costs and benefits of the project.
5. Protection of Funds: Investments are always risky.
Therefore, risk should always be adjusted with return to protect
funds.
6. Distribution of Profits: When revenue is generated from
successful project, a manager’s next function is to distribute
return among different stakeholders. To avail profitable
investment alternative a part of generated profit may also need
to be retained by the finance manager.
1-5
FUNCTIONS OF FINANCE
1. Investment Decision or Long-term Asset mix decision
a. Long-term investment decisions – Long-term assets
b. Short-term investment decisions – Short-term assets
2. Finance Decision or Capital mix decision
a. Shareholders Fund
b. Borrowed Fund
3. Liquidity Decision or Short-term asset mix decision
-“Short term-survival is a prerequisite for long-term survival”
-Liquidity VS. Profitability
4. Dividend Decision or Profit allocation decision
Dividend VS. Retention

1-6
1-7
Which Function is Superior?
NONE…….
Importance of the function depends on the situation of the
firm.
 If a firm has adequate investment opportunities but
experiences difficulty to raise funds, then the finance
function is superior to the firm, at that juncture.
 It does not mean that investment decision is less important
compared to finance decision, always.
 If a firm wants to undertake a project requiring funds, this
investment decision can not be taken, in isolation, without
considering the availability of finances, which is a finance
decision. Both the decisions are inter-connected.
1-8
1-9
1.2 TYPES OF BUSINESS
ORGANIZATIONS.

1-10
Business Organizational Forms
Business
Forms
Sole Partnerships
Corporations Hybrids
Proprietorships
FINC-301, Chapter 1, Russel

1-11
Sole Proprietorship
• It is a business owned by a single individual
that is entitled to all the firm’s profits and is
responsible for all the firm’s debt.
• There is no separation between the business

and the owner when it comes to debts or
being sued.
• Sole proprietorships are generally financed by

personal loans from family and friends and
business loans from banks.

1-12
Sole Proprietorship (cont.)
• Advantages:
– Easy to start
– No need to consult others while making decisions
– Taxed at the personal tax rate
• Disadvantages:
– Personally liable for the business debts
– Ceases on the death of the propreitor

1-13
Partnership
• A general partnership is an association

of two or more persons who come together
as co-owners for the purpose of operating
a business for profit.
• There is no separation between the

partnership and the owners with respect to
debts or being sued.

1-14
Partnership (cont.)
• Advantages:
– Relatively easy to start
– Taxed at the personal tax rate
– Access to funds from multiple sources or partners
• Disadvantages:
– Partners jointly share unlimited liability

1-15
Partnership (cont.)
• In limited partnerships, there are two
classes of partners: general and limited.
• The general partners runs the business
and face unlimited liability for the firm’s
debts, while the limited partners are
only liable on the amount invested.
• One of the drawback of this form is that
it is difficult to transfer the ownership of
the general partner.

1-16
Corporation
• Corporation is “an artificial being, invisible,

intangible, and existing only in the
contemplation of the law.”
• Corporation can individually sue and be
sued, purchase, sell or own property, and
its personnel are subject to criminal
punishment for crimes committed in the
name of the corporation.

1-17
Corporation (cont.)
• Corporation is legally owned by its current

stockholders.
• The Board of directors are elected by the

firm’s shareholders. One responsibility of
the board of directors is to appoint the
senior management of the firm.

1-18
Corporation (cont.)
• Advantages
– Liability of owners limited to invested funds
– Life of corporation is not tied to the owner
– Easier to transfer ownership
– Easier to raise Capital
• Disadvantages
– Greater regulation
– Double taxation of dividends

1-19
Hybrid Organizations
• These organizational forms provide a cross

between a partnership and a corporation.
• Limited liability company (LLC)
combines the tax benefits of a partnership
(no double taxation of earnings) and
limited liability benefit of corporation (the
owner’s liability is limited to what they
invest).

1-20
Hybrid Organizations (cont.)
• S-type corporation provides limited

liability while allowing the business owners
to be taxed as if they were a partnership –
that is, distributions back to the owners
are not taxed twice as is the case with
dividends in the standard corporate form.

1-21
1-22
How Does Finance Fit into the Firm’s
Organizational Structure?
• In a corporation, the Chief Financial Officer

(CFO) is responsible for managing the
firm’s financial affairs.
• Figure 1-2 shows how the finance function

fits into a firm’s organizational chart.

1-23
1-24
1.3 THE GOAL OF
THE FINANCIAL
MANAGER

The Goal of the Financial Manager
• The goal of the financial manager must be

consistent with the mission of the
corporation.
• What is the generally accepted mission of
a corporation?

1-26
Corporate Mission
• To maximize firm value shareholder’s

wealth (as measured by share prices)

1-27
Corporate Mission: Coca-Cola
• “To achieve sustainable growth, we have

established a vision with clear goals:
Maximizing return to shareholders while
being mindful of our overall
responsibilities” (part of Coca-Cola’s
mission statement)

1-28
Corporate Mission: Johnson &
Johnson
• “Our final responsibility is to our

stockholders …when we operate according
to these principles, the stockholders
should realize a fair return” (part of
Johnson & Johnson’s credo)

1-29
Corporate Mission: Google
• “Optimize for the long-term rather than

trying to produce smooth earnings for
each quarter”

1-30
Corporate Mission
• While managers have to cater to all the
stakeholders (such as consumers, employees,
suppliers etc.), they need to pay particular
attention to the owners of the corporation i.e.
shareholders.
• If managers fail to pursue shareholder wealth

maximization, they will lose the support of
investors and lenders. The business may cease to
exist and ultimately, the managers will lose their
jobs!

1-31
Goals of the Corporation
 Primary goal:
maximize stockholder wealth
= maximize stock price
 Managerial incentives
 controlled by competitive forces
 Social responsibility
 must be mandated initially to reduce
disadvantages
 Stock price maximization and social welfare
 Maximizing stock = benefiting society 32
Goal of the Firm:
Maximize Shareholder Wealth
Decision rule for managers: only take actions that
are expected to increase the share price.
© 2012 Pearson 1-33

Prentice Hall. All rights
Managerial Actions to
Maximize Stockholder Wealth
 Capital Structure Decisions
 Capital Budgeting Decisions
 Dividend Policy Decisions
34
Value of the Firm
Market Factors/Considerations
Economic Conditions
Government Regulations and Rules
Competitive Environment
Firm Factors/Considerations Investor Factors/Considerations

Normal Operations Income/Savings
Financing Policy=Capital Structure Age/Lifestyle
Investing Policy=Capital Budgeting Interest Rates
Dividend Policy Risk Attitude
Net Cash Flows, CF Rates of Return, k
Value of the Firm

N
= ^ +
CF ^ ^ ^
CF2 + . . . + CFN = CF
1 t
t=1 35
(1+k)1 (1=k)2 (1+k)N (1+k)t
How Manager’s Actions Affect
Stock Price
 Projected earnings per share
 Timing of earnings streams
 Riskiness of projected earnings
 Use of debt
 Dividend policy
36
Agency Relationships
• An agency relationship = when a principal
hires an agent to act on their behalf
• Within corporations, agency relationships
exist between:
– Stockholders and managers
– Stockholders and creditors
37 1-37
Agency Considerations in Corporate
Finance (cont.)
• Agency problems arise when there is conflict of
interest between the stockholders and the
managers. Such problems are likely to arise more
when the managers have little or no ownership in
the firm.
• Examples:
– Not pursuing risky project for fear of losing jobs, stealing,
expensive perks.
• All else equal, agency problems will reduce the firm

value.

1-38
How to Reduce Agency Problems?
1. Monitoring
(Examples: Reports, Meetings, Auditors, board of
directors, financial markets, bankers, credit agencies)
2. Compensation plans
(Examples: Performance based bonus, salary, stock
options, benefits)
3. Others
(Examples: Threat of being fired, Threat of takeovers,
Stock market, regulations such as SOX)
The above will help to reduce agency

problems/costs.

1-39
1.4 THE FOUR
BASIC PRINCIPLES
OF FINANCE

PRINCIPLE 1: Money Has a Time Value
• A dollar received today is more valuable

than a dollar received in the future.
– We can invest the dollar received today to earn
interest. Thus, in the future, you will have
more than one dollar, as you will receive the
interest on your investment plus your initial
invested dollar.

1-41
PRINCIPLE 2: There is a Risk-Return Trade-off
• We only take risk when we expect to be

compensated for the extra risk with
additional return.
• Higher the risk, higher will be the expected

return.

1-42
1-43
PRINCIPLE 3: Cash Flows Are The Source of Value
• Profit is an accounting concept designed to

measure a business’s performance over an
interval of time.
• Cash flow is the amount of cash that can

actually be taken out of the business over
this same interval.

1-44
Profits versus Cash
• It is possible for a firm to report profits but

have no cash.
• For example, if all sales are on credit, the

firm may report profits even though no
cash is being generated.

1-45
Incremental Cash Flow
• Financial decisions in a firm should

consider “incremental cash flow” i.e. the
difference between the cash flows the
company will produce with the potential
new investment it’s thinking about making
and what it would make without the
investment.

1-46
PRINCIPLE 4: Market Prices Reflect Information
• Investors respond to new information by buying and

selling their investments.
• The speed with which investors act and the way that
prices respond to new information determines the
efficiency of the market. In efficient markets like United
States, this process occurs very quickly. As a result, it is
hard to profit from trading investments on publicly
released information.
• Investors in capital markets will tend to react positively
to good decisions made by the firm resulting in higher
stock prices.
• Stock prices will tend to decrease when there is bad
information released on the firm in the capital market.
1-47

Lecture 1 &amp; 2

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Lecture 1 &amp; 2

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Slide Contents

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

FINC-301, Chapter 1, Russel

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• There is no separation between the business

• Sole proprietorships are generally financed by

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• A general partnership is an association

• There is no separation between the

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Corporation is “an artificial being, invisible,

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Corporation is legally owned by its current

• The Board of directors are elected by the

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• These organizational forms provide a cross

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• S-type corporation provides limited

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• In a corporation, the Chief Financial Officer

• Figure 1-2 shows how the finance function

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• The goal of the financial manager must be

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• To maximize firm value shareholder’s

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• “To achieve sustainable growth, we have

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• “Our final responsibility is to our

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• “Optimize for the long-term rather than

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• If managers fail to pursue shareholder wealth

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

© 2012 Pearson 1-33

 Capital Budgeting Decisions

 Dividend Policy Decisions

Firm Factors/Considerations Investor Factors/Considerations

Net Cash Flows, CF Rates of Return, k

Value of the Firm

• All else equal, agency problems will reduce the firm

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

The above will help to reduce agency

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• A dollar received today is more valuable

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• We only take risk when we expect to be

• Higher the risk, higher will be the expected

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Profit is an accounting concept designed to

• Cash flow is the amount of cash that can

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• It is possible for a firm to report profits but

• For example, if all sales are on credit, the

Lecture 1 & 2

Lecture 1 & 2